Question

​"We R​ Toys" (WRT) is considering expanding into new geographic markets. The expansion will have the same business risk as​ WRT's existing assets. The expansion will require an initial investment of $ 45 million and is expected to generate perpetual EBIT of $ 15 million per year. After the initial​ investment, future capital expenditures are expected to equal​ depreciation, and no further additions to net working capital are anticipated. ​WRT's existing capital structure is composed of $ 550 million in equity and $ 250 million in debt​ (market values), with 10 million equity shares outstanding. The unlevered cost of capital is 8 %​, and​ WRT's debt is risk free with an interest rate of 4 %. The corporate tax rate is 35 %​, and there are no personal taxes.

a. WRT initially proposes to fund the expansion by issuing equity. If investors were not expecting this​ expansion, and if they share​ WRT's view of the​ expansion's profitability, what will the share price be once the firm announces the expansion​ plan?

b. Suppose investors think that the EBIT from​ WRT's expansion will be only​ $4 million. What will the share price be in this​ case? How many shares will the firm need to​ issue?

c. Suppose WRT issues equity as in part ​(b​). Shortly after the​ issue, new information emerges that convinces investors that management​ was, in​ fact, correct regarding the cash flows from the expansion. What will the share price be​ now? Why does it differ from that found in part ​(a​)?

d. Suppose WRT instead finances the expansion with a $ 45 million issue of permanent​ risk-free debt. If WRT undertakes the expansion using​ debt, what is its new share price once the new information comes​ out? Comparing your answer with that in part ​(c​), what are the two advantages of debt financing in this​ case?

Answer 1

a) NPV of expansion =

Here, EBIT = $15 million

(1 - tax rate) = (1 - 0.35) = 0.65

Unlevered cost of capital = 0.08

Initial investment = $45 million

So, NPV of expansion =

NPV of expansion = $76.88 million

Therefore, share price will be = Total equity value / no. of shares outstanding

Total equity = 550 + 76.88 = $626.88 million

no. of shares outstanding = 10 million

So, Share price = 626.88 / 10 = $62.68

b)

NPV of expansion =

Here, EBIT = $4 million

(1 - tax rate) = (1 - 0.35) = 0.65

Unlevered cost of capital = 0.08

Initial investment = $45 million

So, NPV of expansion =

NPV of expansion = - $12.5 million

Therefore, share price will be = Total equity value / no. of shares outstanding

Total equity = 550 - 12.5 = $537.5 million

no. of shares outstanding = 10 million

So, Share price = 537.5 / 10 = $53.75

New shares needs to be issued = Initial Investment / Share price

New shares needs to be issued = 45 / 53.75 = 0.84 million shares

c) Share Price will be =

New share price = $61.98

The share price is now lower than the answer from part (a), because in part (a), share price is fairly valued, while here shares issued in part (b) are undervalued.

New shareholders’ gain = (61.98 - 53.75) * 0.84 = $7 million

Old shareholders’ loss = (62.68 – 61.98) *10. = $7 million

d) Tax shield = 35% of 45 million = $15.75 million

Share price =

So, Share price = $64.26

Gain of $2.28 per share compared to case (c)

Advantages:

1. Avoid issuing undervalued equity, and

2. Gain of $1.57 per share from interest tax shield.